Insurance for all bank deposits is a manageable cost

Agroup of conservative Republican representatives known as the House Freedom Caucus came out last week against any proposal that would lift the cap on deposit insurance, now set at $250,000. Members of the US Congress on both sides of the aisle are understandably cautious about taking such a dramatic step in the middle of an unfolding crisis.

But though it would be a mistake for legislators to try to repair the instability in the banking sector with hastily drafted legislation, it’s becoming clear that any solution needs to include legislation providing comprehensive insurance to all retail banking deposits in the US.

No doubt, expanding deposit insurance without placing additional risk on taxpayers will require a substantial increase in reserves held by the Federal Deposit Insurance Corporation (FDIC). But there is precedent.

During the financial crisis of 2008 and 2009, the FDIC went well beyond what was necessary to ensure the safety of deposits when it used its own funds to partially cover uninsured depositors at large institutions such as IndyMac. The logic was that it would be cheaper to ensure all depositors at too-bigto-fail banks than to allow a general banking panic, which could induce runs on dozens of other financial institutions with partially guaranteed deposits.

Yet it was seen to many as unfair, inefficient and systemically risky for uninsured depositors to have this sort of quasiguarantee without banks being charged a fee for the backstop.

The Dodd-Frank Act went part of the way in solving this problem by requiring banks be assessed deposit insurance fees based on total liabilities rather than just insured deposits. But changing the formula still leaves several problems unaddressed.

First, while all banks pay fees based on their total liabilities, it is only large banks that receive an implicit guarantee on all deposits. This encourages runs on medium-sized banks, with Silicon Valley Bank (SVB) being a prime example.

When depositors became worried about the soundness of SVB, they didn’t pull their money out in the form of physical cash or invest it all in gold coins. They simply wired the money to an account at a large, too-big-to-fail bank. This process has become so fast and easy that there is no incentive for a depositor to conduct due diligence on a bank’s health. This is the opposite of what deposit insurance is supposed to achieve. Yet it’ s what should be expected in a system that gives implicit guarantees to only the largest banks rather than an explicit guarantee on all deposits to all banks.

The underlying logic of putting a cap on deposit insurance is that it encourages the largest and most sophisticated depositors to keep an eye on a bank’s risk management. In theory, yes, but SVB and Signature Bank show that’s not what happens in practice. Tech firms with large deposits at SVB were seemingly oblivious to the risks. Even in theory, it would be unreasonable to think depositors have a deep enough understanding of finance to appreciate the type of bond market risk that undermined SVB. To even sophisticated depositors, the bank’s decision to invest in US Treasury bonds, when it couldn’t find suitable loans, seems like a responsible decision.

Moreover, the fundamental mistake assuming that Treasury yields accurately reflected term risk was one that many leading economists, including those at the Federal Reserve, made. Few economists anticipated persistent inflation that would require the most aggressive series of rate hikes in history as a strong possibility before 2022. It was those hikes that drove down the value of SVB’s holdings of Treasuries. Once its bonds fell in value, it was prudent for SVB to hold on to them, as selling them at a loss would have and eventually did precipitate the crisis of confidence that brought the bank down.

And even though there is an implicit guarantee on at least some uninsured deposits, the FDIC historically levied only enough in total fees to cover insured deposits. This caused the FDIC to deplete its funds during the previous financial crisis and it has been underfunded ever since. The FDIC did increase the base rate it charges banks from three basis points to 5 bps. Adequately covering the total deposit base in the US of $18-trillion would require the FDIC to hold roughly twice the funds needed to the now insured deposit base of $10-trillion. That would necessitate a further increase in the FDIC’s base rate to between 9 bps and 10 bps.

An increase of that size is enough to take a meaningful chunk out of bank profits of about 6%, according to past FDIC analysis. Yet it’s less than the hit regional banks took to their share prices just after SVB. It’s also roughly the percentage of profits that banks were paying for deposit insurance in 2011 an added burden but one that’s eminently manageable.

To cut the risk on taxpayers, level the playing field between banks, and lessen the likelihood of bank runs, Congress should expand the FDIC’s guarantee to all bank deposits and increase the fees to align with the actual risks that are being insured.

There are those who are worried a blanket guarantee would encourage risk-taking, but sticking with the current system is the bigger risk.

THERE ARE THOSE WHO ARE WORRIED A BLANKET GUARANTEE WOULD ENCOURAGE RISK-TAKING, BUT STICKING WITH THE CURRENT SYSTEM IS THE BIGGER RISK